“I don’t see an inconsistency in the recent performance of stocks and bonds because stock values are fundamentally determined by the present value of expected cash flows”, Ray Dalio said, in a July interview centered around the purported “disconnect” between plunging bond yields and surging stock prices in 2019.
“When the Fed shifted to a much easier stance, it made sense that both interest rates fell—which was good for bonds—and stock prices rose”, he added.
2019 has been the year of the “everything rally”, and the most visible manifestation of that is the disconnect between what were, until recently, record high stock prices and the lowest bond yields of the Trump era.
The apparent “anomaly” shown in the chart isn’t really perplexing. The explanation is that stocks are hoping the Fed has enough ammo and credibility to head off a recession and bonds are reacting both to the promise of a return to accommodative policy and the economic weakness which necessitated the dovish pivot in the first place.
Meanwhile, all assets are bolstered by the promise of perpetual liquidity provision from the benefactors with the printing presses.
In early July, markets were pleased that stocks were able to push higher even as bond yields rose. That appeared to suggest the door was open to good news being interpreted as just good news again, as opposed to the all-too-familiar post-crisis dynamic that reasserted itself this year wherein good economic news is actually “bad” news to the extent it might make central banks rethink their commitment to policy easing.
The flipside of that dynamic is that bad news is actually “good” for risk assets, as it underscores the need for rate cuts and other accommodation from monetary policymakers.
The problem with that perverse state of affairs is that if the news gets so bad that market participants begin to believe no amount of central bank action will be sufficient to avert a recession, risk assets like stocks will “catch down” to the economic reality telegraphed by falling bond yields.
Well, in August, stocks begin to treat the worsening economic outlook and trade frictions pushing bond yields lower as just plain old bad news. Worse, risk assets appeared to interpret a trio of surprise rate cuts from New Zealand, Thailand and India, as evidence that things really are quite dour.
The figure shows the first couple of weeks in July, when good news briefly became good news again (i.e., bonds fell and stocks rose as the outlook brightened) and the last two weeks, when the outlook darkened enough for risk assets to start pondering the possibility that a downturn is coming no matter what central banks do (i.e., bonds rallied and stocks fell).
“For most of 2019, the prevailing theory was that the rally in bonds did more to support risk assets, through boosting valuations and expectations for looser Fed policy, than hurt them, by reflecting lower future growth expectations”, Bloomberg’s Luke Kawa writes, in the latest edition of “The Weekly Fix” letter (you can sign up here).
As noted above, that “prevailing theory” only applies up to the point beyond which market participants decide that bond yields are conveying something overtly and inescapably dour.
“The limitations of this worldview were laid bare this week. Bonds were the foundation of the rally; now they’re the bricks in the wall of worry”, Kawa goes on to say, before driving the point home by noting that “this week, equities didn’t rely on bonds to tell them they were worth more, they relied on them” as a barometer of global growth, while “larger-than-expected central bank easing from around the globe intensified investors’ fears about just how poorly activity was expected to evolve”.
That manifested itself in positively correlated intraday moves between equities and yields.
If you want a more granular breakdown that helps make the same point, have a look at the following chart from Goldman, which shows cross-asset performance broken out by time frame (July 29-August 6; June 3-July 29; April 17-June 3; December 24-April 17):
Note that the only assets which performed from July 29 through Wednesday were long bonds in German and the US, benchmark US Treasurys and German bunds, gold, the yen, low volatility stocks and the franc.
Since the July FOMC, bad news has just been bad news, which means risk assets stumble, and havens are bid whenever there’s a hint of trouble.
The implication is that stocks have seen about all they care to see of plunging bond yields. At this juncture, equities would probably be just fine with seeing long-end yields rise on solid data, trade optimism or, ideally, both.